Sunday, February 22, 2009

I've been phenomenally busy of late - I hope to get back to posting more regularly sometime this week. For the moment, here is a free piece of genius that will make you a small fortune, if the analysis holds up.

The carnage in
financial markets this week has done some serious technical damage -
the Dow's breach of the November low (I TOLD YOU SO) has brought the
Industrials into line with the new lows made by the Transports, and
thus a new Dow Theory bear market confirmation has been borned.

Add to this, that the investing public seems to have
completely lost faith with the Magic Mulatto and his band of 'more of
the same' dills, and you have a recipe for Dow 6000 in relatively short
order. I fully expect that to occur later this year, but the Herd
expects it to occur next week.

So for the present, I think it's time to skin some
newbie-short nuffnuffs.

Confession: I got torched
this week, having taken a position trade (long) in DAX
futures.

The confession comes with a caveat: as with the 30-year bond
short, this has a horizon longer than its life to date.

Like the bond short, it went underwater - hard - which would
spook anyone who wasn't as good as me.

Like the bond short, it will finish profitably, but in over a
shorter timespan than the bond short (which is still live).

The DAX long was undertaken with the market already oversold
on all but the weekly timeframe... and now the DAX is weekly oversold
as well (it's even oversold on a monthly basis).

When it comes to the decision to take a position - rather
than a series of scalps - your beloved GT doesn't just decide to do a
thing in the heat of the moment: although the analysis is reasonably
straightforward, it is comprehensive. (Note - 'position' here means
something that has a trade life of more than a couple of days, and
anticipates an exit with the underlying instrument priced 5-10% higher
than the entry level).

So let's look at the DAX position. This extends
to equity markets more broadly, although Australia was spared
much of the week's carnage and thus will not bounce anywhere near as
forcefully.

For sentiment
analysis I'll use US data (OEX option put-call, S&P futures
CoT), because although DAX-specific data is available (only from me - I
produce it myself), the US serves well as a proxy for all equity
markets at sentiment extremes. Also, if I use non-proprietary
data you can check the US-data calcs easily using public
resources, whereas you can't check anything I say about things that
only I generate for European markets (unless you do a lot of tedious
data-collection and calculation).

The analysis proceeds based on a few core measures, which can
be grouped under two primary headings: Technical Extremes and
Sentiment Extremes. Of particular interest are divergences between
the instrument and its CCI, coupled with a heavily oversold reading on
the Williams %R.

Our lietmotif is that the crowd is always wrong when they all
think that there is free money in the same direction as the dominant
trend.

You will notice that I have said nothing whatsoever about
valuation or any fundamental measures - PE, Yield, or what-have-you.
That's because I am not advocating the end of a bear market: I fully
expect the market to bottom at an undervalued condition (with the PE on
the S&P500 at between 7 and 10 based on trailing earnings), at
an S&P level of at most
450 - with a 25-30% chance of a final Dow level of 1000. Sounds
terrifying, but that's just how it is: we're not going to get there in
a straight line, and we're not going to get there next week or next
month.

All we are talking about in this exercise is a bear-market bounce which
will clear a very heavily oversold condition. We are not looking for a
new bull market, and in fact we are not even looking for a bounce which
would be good enough to remove portfolio hedges; Australian markets
have not fallen as far, and will not bounce as far, as either US or
European markets. But it will be eminently hold-able - probably for two
weeks starting after a crack downwards in the German market in the
first hour of the cash market on Monday.

First, let's get a handle on the oversold-ness of the DAX at
present. By the end of this post you will see the sentiment stuff as
completely unnecessary, but I will post it tomorrow if I have the time. Suffice it to say that journalists are talking about a bear continuation - that ought to be enough to signal a contrarian snapback.

Everybody who reads the Rant knows my preferred
oscillator combination: during a downtrend (do you think?) a long
position on a given timeframe can only be taken if there is a CCI
divergence on that timeframe. For a divergence to be valid, the
conditions are reasonably onerous:

the initial CCI extreme must be greater than 200 in
absolute value (+200 for shorts, -200 for longs);

the Williams %R must be in appropriate 10% of its range
(-90 for longs, -10 for shorts); and

there must be at least one period in which both the low
(high, for shorts) of the bar is higher (lower) than the low (high) of
the initial CCI extreme.

For counter-trend moves, the exit is to be taken at
the next %R overbought (oversold, for shorts) or the intervening swing
high (low, for shorts), whichever occurs first.

A diagram will help bring this out (click on the chart below
to get a bigger version):

DAX Daily Chart - Was Ist Los?

So let's break it down - look at the divergence back at the
late October low: The first low (on October 11th) was at 4306 (marked as 'A'); CCI was
deeply oversold, and %R was solidly in oversold territory too. This
deeply oversold condition was followed by a little burst upward to as
high as 5383 on the 15th - a thousand DAX points in two
sessions.

Once this bounce (and more) was given back, the DAX
retreated to a closing low of 4267 on October 28th (marked as 'B'), but note that the
CCI made a higher low.

Thus a divergence was born - and the swing high (5383) became
the target for the bounce.

Just 6 sessions after the CCI divergence, the DAX closed at
5307: it was within the day's range of the target day, and more
importantly the %R registered an overbought reading.

So that's how a CCI divergence works (and they work about 80%
of the time).

For the current divergence ('C' and 'D', with 'C' a slightly messy non-divergent range), the target is as shown on the
chart as 'Target B',
which is a DAX level of 4688, some 675 points above the Friday
close. At present the
%R target would be 3894+0.9×(4695-3894), which equals 4614 (which is
within the trading range of the day marked as Target B): if the
bounce takes place in less than a week, that will remain the target.

A second string to the analytical bow on the oversold-ness
front (for daily timeframes) is the deviation from a
longer-term moving average: to guage position entries I prefer the
200-day.

There have been four periods since 1991 during which the DAX
has been 25% or more below its 200-day moving average: September 2001,
October 2002, March 2003, November 2008 and January
2009.

All have coincided with subsequent rallies, the smallest of
which was 500 DAX points.

More importantly, from the first day on which a 25% deviation from the
MA200 occurred, an exit 400 DAX points higher was possible every single time.

The latest day on which the DAX dropped to a level 25% below
its 200-day MA was February 17th, at a closing price of 4216: adding
400 DAX points to that level as the minumum upside objective gets you
to - again -
4616...
within the day's range for the swing high marked as Target B.

This is the Technical Case for holding a DAX long. The targets
are grouped around the 4615 level, with a maxuimum objective of 4688.

As I have mentioned, my current long position which
was well underwater on Friday, was taken off near the close in
order to be re-established at a lower price on Monday, since the DAX
will almost certainly open with a small gap to the downside.

When the DAX hits 4600-odd (it is actually possible that this
happens before the end of this
week) you will shake your head in amazement, and I will say "I told you
so".